Principles help us understand our environment and give us tools for making good decisions. During periods of stress and volatility in the financial markets, we refer to principles to guide us as we manage money. We wanted to share five of those with you to guide your understanding of the current environment and help you make good investing decisions.
One: Stocks are shares of businesses.
When stocks drop rapidly, it is hard to remember that they aren’t just pieces of paper with no intrinsic value. Stocks are literally shares of businesses – in just the same way that the local hardware store is a business. Unlike the local hardware store, though, the value of publicly-traded companies is priced continually. We work to invest our clients’ money in shares of great operating companies. In the current environment it is reasonable that stock values have declined some. After all, we are in the midst of a voluntary economic shutdown which will negatively impact 2020 revenues and profits. When normalcy returns, these companies will return to operating for growth and profits.
Two: High quality bonds return your money at a specific date.
Bonds are senior to stocks in a company’s capital structure, which means that companies must pay bondholders before they distribute or record profits for shareholders. High quality bonds pay interest and return principal at specified dates. High-confidence, predictable cash flows from bond interest and principal repayments allow investors to withdraw money from their portfolios without selling stocks at temporarily depressed prices.
Three: Investor pessimism overshoots more rapidly than optimism.
There is an old adage: “Bull markets never die of old age”. We are living that reality now. The bull market at the end of 2019 was in good shape: nearly 11 years of expansion with growing profits and a solid economy. Yet stocks were also not terribly overvalued. However, the shock of COVID-19 came on suddenly, ending the string of strong stock returns since 2009. However, while the recovery will likely take longer than the drop has, we see no reason to fear a deep recession. The conditions and the cause make this contraction nothing like the housing crisis and the 2008-2009 bear market, which is freshest in investors’ memories.
Four: Rapid information flow takes time to process.
One of the best ways to understand a company’s intrinsic value is that it’s the present value of its future profits. Setting reliable estimates for future profits is difficult enough when markets are calm. When shocks like the COVID-19 pandemic occur, analysts require more time to estimate how corporate profits should fare in the next several quarters and what it means, if anything, for long-term growth trajectories. That’s where we are now: news is fast and market reactions are fluid. It will take time to process the data and develop expectations for the future.
Five: Capitulation reinforces destructive habits.
Owning stocks over many years is a proven wealth creator. The dark side of the stock market is that it is very good at using investors’ emotions against them during times of panic and euphoria. The urge to sell after a deep decline and wait until “things feel better” to get back in, is one trap. Here’s the problem with that plan: when will things feel enough better to get back in? If you suffer a 30% decline in value and decide to sell, what will your reaction be when the market recovers 10%? In real time this strategy is impossible because no one knows if the first 10% up is the start of a march back to the old highs or just a head fake before another leg down. Investors who liquidate stocks tend to stay out of the stock market rather than getting back in as planned – they diminish the improvement in stock prices because the pain of having sold near the bottom compounds the pain of the original 30% decline. We urge asset allocation changes based on your unique needs and time horizon, not market volatility.
This bear market, like its predecessors, is miserable to experience. Its descent has been historically sharp – both in speed and depth. Remember during this time that your stock investments are still shares of companies, that it will take time for everyone to process the new landscape, and that throwing in the towel now may well come with a very high long-term cost. These principles have served investors well in every other time of market turmoil. If you’d like to discuss the markets or your portfolio further, we welcome the opportunity to speak with you.